Your email address will not be published. Required fields are marked *

Comment

Some HTML is OK

Sign me up for the Money Morning newsletter

Name *

Email *

Website

two × seven =

By Martin Hutchinson
Contributing Editor

I have been much more positive about the Japanese economy than most other analysts in recent months, largely because I believed that many of the problems from the Japanese recession of 1990-2003 were finally in the country’s rearview mirror. In particular, I believed that the Japanese budget deficit – which, by 2003, had become quite acute – was well on the way to being solved through public spending restraint. That, in turn, would allow Japan to pay down its excessive public debt, giving its private sector room to expand.

But the surprise resignation of Japanese Prime Minister Yasuo Fukuda on Monday suggests I may have been wrong about the country’s near-term prospects.

Japan Gives Investors a Bubble Bath

The Japanese stock market and real estate bubble of the 1980s is now the stuff of stock-market legend, for it sent that country into a tailspin in 1990-91, after which came more than a decade of very slow growth. There were a number of causes – one was the appalling quantity of rubbish loans that Japanese banks had put on their books during the bubble (sound familiar…. perhaps we are we seeing a reprise here in the U.S. market?), and the second was the inexorable expansion of the Japanese public sector.

Prime minister after prime minister would propose “stimulus packages” of public spending, mostly on roads and bridges in rural areas (always popular with politicians from those areas). The largest package – by Prime Minister Ryutaro Hashimoto in 1998 – was more than $400 billion, the equivalent of 10% of Japan’s gross domestic product (GDP).

Apart from covering Japan’s beautiful scenery with unsightly overpasses, these capital infusion packages had two very clear effects:

They increased Japan’s public spending – from 31.5% of GDP in 1991 to 38.1% of GDP in 2002.

And they created a huge public debt problem; Japan currently has public debt of 182% of GDP, the highest ratio in the world.

These stimulus packages had one very obvious shortcoming – they didn’t stimulate. And with good reason. These programs did nothing useful to revive the Japanese economy because the mostly useless public works projects they financed (in terms of GDP, these projects were more than twice as large as those of the next-most-profligate public-works spender – France) were using up all the domestic capital that should have been financing private-sector growth. In the parlance of economics, this is known as “crowding out,” and can be quite damaging, as Japan’s experience demonstrates.

Japan’s Prime Minister Troika

Since 2003, the key figure in Japan’s economic recovery is former Prime Minister Junichiro Koizumi (2001-06), who stopped building “bridges to nowhere” – prompting major protests from the Liberal Democratic Party (LDP) “old guard.” That stopped the growth in debt and then gradually brought the budget deficit down. As a result, Japan’s economic growth resumed in 2003.

Koizumi was succeeded briefly by Shinzo Abe, and then by Fukuda. Like Koizumi, Fukuda was a proponent of reducing public spending – he wanted to balance the Japanese budget by 2011. Indeed, Koizumi and Fukuda were actually quite close: Koizumi got his political start under the premiership of Fukuda’s father (also a tight-budget man) in the 1970s. So you can see why I was so confident that Japan’s public spending would be kept under control and that the Japanese economy would continue recovering.

Fukuda’s weakness was demonstrated by his Aug. 1 appointment of his political opponent, Taro Aso, as secretary general of the LDP. When Fukuda’s cautious Aug. 29 stimulus package of $18 billion – which consisted mostly of loans – was decried as inadequate, he realized that the clamor for extra spending would be unstoppable, and resigned.

Fukuda will likely be succeeded by Aso, a protégé of the big-spending barons of the rural constituencies.

Déjà vu all Over Again

The bottom line is that the public sector is likely to grow again, as it did in the 1990s, producing larger Japanese budget deficits, packing on more debt and stifling private sector development. Since Japan’s public debt is already so high, the chances are good that the country’s debt rating of AA (Standard & Poor’s) /Aa3 (Moody’s Investors Service (MCO)) will be downgraded. That would increase borrowing costs for all Japanese companies and damage the economy badly.

For more than a year, I had been positive on the Japanese economy, even as the market declined. But it’s finally time for a shift in outlook:

In the near term – until the political situation can be sorted out – it’s better to underweight Japan in our portfolios.

In the meantime, until it becomes clear that this China-Japan connection can pump up the Japanese economy, there’s another Asian market – actually, one of the “Four Asian Tigers” – that’s clearly worth a look as an alternative.

And that market is Korea.

Korea’s Profit Promise

The Korean government recently improved with the election of president Lee Myung-bak and a pro-business party with a substantial majority. Korea’s economic growth is likely to accelerate, particularly if we have seen the worst of the commodity and energy bubble, since Korea is primarily an importer of commodities and energy goods.

The Korean stock market has been beaten down this year, dropping 20%, and currently trades at only 10 times earnings. But this low valuation is undeserved, since the Korean economy is expected to grow at better than a 4% clip for both this year and next, according to the respected global-economics magazine, The Economist.

Take a look, for example, at the Korean exchange-traded index fund (ETF), the iShares MSCI South Korea Index Fund (EWY), which tracks the Morgan Stanley Capital International Korea index. The ETF currently carries a Price/Earnings (P/E) ratio of 10.3 and features a dividend yield – after expenses – of about 1.9%.

It should be noted that Australia has been a more profitable trading partner for China than Japan as Australia has the natural resources (building blocks of an economy) China needs. Japan offers little in that regard. The two cultures of Japan and China are not generally cozy so a scenario of these two together seems less likely to me than the esteemed and respected author opines.

What is also worth noting concerning the expansion of the Chinese is the strong relationships they have been quietly building with Africa nations. This vast continent is rich in natural resources and may offer cheaper labor options for the Chinese as well down the road as the Chinese demand higher wages. This arrrangement should be a win-win for both sides for years to come and I see Africa replacing much of the supply currently coming from Australia. So with all due respect it seems the Chinese have a plan for expansion that doesn't include the Japanese.

The Japanese will have to look elsewhere for help…perhaps it will come from the USA as better trade agreements could increase their exports. Quality products are what made Japan prosper and i hope they continue to challege the world with advanced technology as their prosperity (and the benefit of the world) seems linked to their following such a path. My recommendation would be for them to try hard to improve everything they can that forwards humanity, and especially those things most in demand and with the most demand potential in the future. For example, playing video games may be a fun way to waste a life but it offers less good than bad so perhaps they should now look to improving infrastructure quality (bridges, airports, power plants, polution control, etc) with minimized expenses. This would be a way to help emerging nations prosper and thus link Japan with the prosperity of such nations. Or perhaps solutions that help ease inflation in already developed nations…like ways to reduce fuel and food costs through advanced business technologies or practices. Such advances would be win-win and not only help Japan out of their slump, but would benefit the whole world.

Also, the author points out how our current predicament here in the USA seems eerily like what Japan has recently faced. Thus there may be lessons (hopefully our best government thinkers will review carefully) to be learned here.

One additional lesson that seems new to the equation may be the impatience of the Japanese with their government as they are giving liberals another chance. This might already reflect the level of frustration already here in the USA as people vote.

Looking back since 1936 i see little difference in the economy based purely upon what party is in power as instead our economy seems more a reflection of our nation growing up and discovering new and better ways to function. Our greatness seems to have been our ability to continue to work to improve our nation as we have incentive to improve our lives. My concerns here are that we may have reached our apex of greatness and on our way down. I hope that is not the case but (for example) today i stopped to buy two coffees and a cookie and the tax was 12.5%. This is a real problem that can demoralize our incentive to prosper. More people may just decide to quit trying and just depend upon the government to bail them out. So instead of contributing to the economy and our society we are making it more attractive for people to expect their government to bail them out. This seemed less the case twenty five or thirty five years ago. I remember paying 49 cents for coffee with one cent as tax (2%). Coffee has gone up four times in price, but the tax on coffee has gone up six times. Taxes can hinder economic stimulation and liberal politics seem bound and determined to bring us this way while conservative politics seem bound and determined to increase our national debt. The public doesn't see conservative politics working the last couple of years and may be like the Japanese wanting "change."

Some problems are bigger than even our brightest and best so maybe we need to get on our knees and commit to what is written on our money…"in God we trust."

Silver is essential to a balanced portfolio – this safe-haven asset will hold its value against geopolitical conflict and market volatility. And silver has real potential to see double-digit gains this year. Find out why silver prices are set to surge, plus the four best ways to invest in silver now. Enter your email below to get the report.

Money Morning gives you access to a team of ten market experts with more than 250 years of combined investing experience – for free. Our experts – who have appeared on FOXBusiness, CNBC, NPR, and BloombergTV – deliver daily investing tips and stock picks, provide analysis with actions to take, and answer your biggest market questions. Our goal is to help our millions of e-newsletter subscribers and Moneymorning.com visitors become smarter, more confident investors.